Some market watchers will believe the Federal Reserve’s decision today to cut the federal funds rate for the first time since 2008 is significant. Some will see it as a triumph of dovish monetary policy. Others will condemn it as a reckless reduction that runs the risk of overheating the economy.
Yet others will see it as a worrying sign of politics encroaching on the Fed’s independence.
In reality, the Fed’s rate move is none of those things. Nor is it surprising. Why? Because once again, the Fed has simply followed the freely traded bond market in its decision.
Most people believe that central banks set interest rates. In actuality, they follow interest rates set by the marketplace. (See the evidence in Europe, the U.K. and Australia here.)
Our December article noted that the federal funds rate hike that month followed increases in the three-month and six-month U.S. Treasury bill yields set by the market.
Our March article pointed out that the Fed kept the federal funds rate unchanged following a months-long sideways move in T-bill rates.
Our June article observed that although the Fed once again kept the federal funds rate unchanged, we expected the Fed to change course soon, as the gap was growing between the yield on short-term T-bills and the fed funds rate. We said, “The market is signaling that at some point in the coming months, the Fed will lower its fed funds rate to align with T-bill rates.”
And change course it did.
This chart shows that the spread between T-bill yields (yellow and green lines) and the fed funds rate (red line) had been widening steadily since May. Thus, the market led the way to lower rates, and the Fed followed on Wednesday.
As we noted in our June article, the same phenomenon occurred in 2007. By mid-June of that year, the 3-month U.S. T-bill yield had fallen nearly 75 basis points below the fed funds rate. The gap between the two rates grew even wider, and at its September 2007 meeting, the Fed finally brought the funds rate in line with the market. The Fed chased T-bill rates lower in a series of rate cuts in 2008, dropping the fed funds rate to 0.25% in December 2008.
While most investors and pundits scrutinize factors like unemployment, political pressure, consumer confidence and other fundamentals to forecast the Fed’s next move, the best way to anticipate the Fed’s decisions is to simply look at T-bills.
Steven Hochberg co-edits Elliott Wave International's Elliott Wave Financial Forecast with Peter Kendall, writes the Short Term Update thrice weekly, and provides commentary on the U.S. stock market, interest rates and precious metals for Global Market Perspective. Over the years, Hochberg has become a sought-after lecturer and has been quoted in various media outlets, such as USA Today, The Los Angeles Times, The Washington Post, Barron’s, Reuters and Bloomberg. He has also discussed financial markets on CNBC, MSNBC and Bloomberg Television. Hochberg began his professional career with Merrill Lynch and joined Elliott Wave International in 1994.
Peter Kendall co-edits Elliott Wave International’s Elliott Wave Financial Forecast with Steven Hochberg. He also provides commentary on cultural trends, the economy and the U.S. stock market for the firm’s Global Market Perspective. Kendall began his career as a financial reporter and columnist in 1983. He wrote “On the Money,” a column for The Business Journal, from 1991 to 1997. Kendall joined Elliott Wave International as a researcher in 1992 and served as the director of EWI’s Center for Cultural Studies, where he focused on popular culture and the new science of socionomics. He has been contributing to Global Market Perspective since 1995, and he also contributes to EWI’s Short Term Update. He graduated from Miami University in Oxford, Ohio, with a degree in business administration.
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